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After a stronger-than-anticipated first quarter, the U.S. economy began to experience conflicting cross currents...



The Road Ahead | Second Quarter 2019

July 30, 2019
By Peter Sorrentino, Chief Investment Officer

The Economy

After a stronger-than-anticipated first quarter, the U.S. economy began to experience conflicting cross currents, as reported manufacturing activity dipped in five of the Federal Reserve Bank districts, housing activity tapered off, and auto sales appeared to falter. In contrast, employment, wages and retail sales continued to advance, and overall sentiment indicators gave little indication of a dramatic dour turn by consumers. Many of the data series have become notably more volatile since the financial crisis, and the magnitude of the statistical errors is such that it is often more informative to look at the magnitude and direction in the prior period revisions for direction and strength of the segment in question. This much is certain: housing remains largely on the sidelines in this recovery, and housing price appreciation has slowed nationally and, in selected markets, has fallen as rule changes regarding ownership disclosure have chastened some foreign investment.

One of the more surprising developments in this cycle is the impact of the trade tariffs on small and medium-sized domestic companies. Generally, these companies experience some of their best returns late in an economic cycle as production limits constrain supply, thus pushing prices and margins to higher levels. The globalization of the supply chain has reached such a degree that these smaller concerns are dependent upon offshore suppliers for critical componentry. And, as tariffs impose higher costs and supply channels become strained, these companies are now coping, not only with tight labor conditions, but with rising input costs. These factors have combined to short-circuit the historic pattern of profit growth. With wages and import prices rising, we would expect to see an upward push in inflation. That, too, has not occurred as energy prices appear unable to sustain a material advance with ever-rising U.S. production and now exports serving to cancel out OPEC’s efforts to hold the line on oil.

Other basic materials are also struggling to move higher as demand falters on slowing growth, and the overhang of surplus capacity from the previous commodity cycle limits what gains have been made. The one bright spot may be the agricultural commodities, as an outbreak of swine flu has decimated China’s hog in herds, and an extraordinarily wet spring negatively impacted U.S. wheat and corn planting. The full impact of these events will continue to play out over the second half of the year, but so far, they have served to push prices for these commodities up roughly 15%. Overall, the U.S. economy continues to forge ahead with little indication of the sort of excesses that require a recession to correct. Our positive outlook on the economy translates into a positive outlook for the U.S. equity market, but the tepid nature of this growth makes us vigilant regarding potential excess building within the financial markets that, if triggered, have the potential to spill over into the economy.

Equities

The domestic equity market began the quarter following up on the strength of the opening months of 2019. The advance continued until the first week of May where, after posting a new high, stock prices began to retreat as global trade disputes escalated. This led to a month-long pull-back that ended on June 3rd, at which time comments from Federal Reserve Chairman Powell indicated that the central bank would consider the adoption of a more accommodative monetary policy, if needed, to extend the economic advance.

Stock prices recovered most of May’s decline, as the market finished the quarter fractionally below the May 3rd record. The stocks most responsible for the positive quarter were the insurance carriers within the Finance sector. As most insurance companies resemble closed-end bond funds, the prospect of lower interest rates boosted the value of the insurer’s bond holdings. Following close behind Finance were the consumer-oriented Technology stocks, where the 15% advance of software creator, Microsoft, carried the sector. The weakest sector among the domestic stocks was the Energy sector, which was in keeping with a modest decline in energy commodity prices during the period. The weakest group with the domestic stocks were the Transports. A combination of lost revenue (due to the imposition of tariffs) and the unexpected costs associated with the grounding of the Boeing 737 Max aircraft to pressure results for the major carriers contributed to the weak performance.

Market capitalization returned as a significant determinant of price performance as witnessed by the return of the Russell 1000® Index (+2.54%) as compared to the return for the Russell 2000® Index (+0.7%). With the decline in interest rates, growth once again took center stage as the Russell 1000® Growth Index outpaced the Russell 1000® Value Index by an almost three to two margin. International markets opened the quarter closely, tracking one another until the first week in May when the developed markets (principally European) pulled ahead of the emerging markets. The prospect of the G-7 central banks lowering short-term interest rates buoyed prices in those markets, while the emerging markets were confronted by the prospect of slowing global growth, which would reduce the demand for the raw materials often supplied by these emerging economies.

Exhibit 1 (Source: Bloomberg)

Exhibit 2 (Source: Bloomberg)

Fixed Income Markets
Municipal bonds continued drawing buyers as witnessed by the unbroken string of weekly capital inflows. This unrelenting demand pushed the available yield on municipal obligations down roughly 15 basis points across the term structure for generic A-rated general obligation bonds. New issuance remains subdued, leaving investors to search the secondary market places to put money to work.

The corporate credit market enjoyed strong demand as well. The term structure for the generic A-rated corporates fell by almost 46 basis points during the quarter. As was the case for municipal debt, a light new issuance calendar boosted prices for sellers in the secondary market. The widening of credit spreads for corporates as compared to Treasuries reversed during the quarter, as the term structure for the Treasury market declined by 40 basis points, thus tightening the spread range by almost six basis points.

The health of the current economic expansion and corporate profit outlook have calmed concerns regarding deteriorating credit quality in the corporate bond sector. Non-dollar denominated debt enjoyed a sharp rebound following the news of a potentially more accommodative stance on monetary policy by the U.S. Federal Reserve Bank in late May.

 

Exhibit 3 (Source: Bloomberg)

 

Exhibit 4 (Source: Bloomberg)

Commodity Markets
Volatility continues to expand as weather and geopolitics join forces to roil the various components within the commodity complex. Persistent heavy rains delayed Midwest farmers from harvesting spring wheat and planting corn. As a result, corn prices rose 12.4% per bushel, while spring wheat gained 13.7% per bushel.

The prospect of higher feed prices served to push livestock prices down, as traders assumed farmers will likely reduce herd sizes rather than suffer higher feed costs. Events in the Middle East, attacks on production facilities in Saudi Arabia and oil tankers in the Strait of Hormuz, would briefly drive prices higher only to be pulled back down by even greater production from North America’s shale fields. At quarter’s end, the price per barrel of crude oil had slipped 3.6%.

The only part of the energy complex to post a gain for the period was the price per gallon of regular unleaded gasoline. A major refinery fire in the closing days of the quarter was enough to nudge the price of gasoline up 1.4%. Industrial metals continue under the cloud of slowing global growth with copper priced down 5.8% and finished steel unchanged.

 

Third Quarter Outlook

Equity Market
With the prospect of easing monetary policy as a backdrop, falling interest rates should serve to support equity prices and limit the magnitude of market declines. This environment will reinforce the market leadership, that of large cap stocks over small caps and growth stocks over value. We look for U.S. economic and corporate growth to outpace that of the other developed economies during the period and, therefore, expect U.S. equities to deliver better returns.

The question not yet answered is the impact on emerging economies and markets. Should the U.S. dollar reverse its strengthening trend, these markets would be poised to rally. If, on the other hand, the U.S. dollar were to continue to strengthen, the emerging markets will suffer, not only from adverse currency exchange but continued slower export demand growth. Among the domestic market sectors, falling rates will likely pressure lending margins for the banking sector while boosting returns for insurers and asset managers. Lower mortgage rates will support home sales and the Consumer Discretionary stocks in general.

The converse will be true for the Consumer Staples, as the lack of inflation pressure limits their pricing power, while rising wage and benefit costs continue to squeeze profit margins. Industrials will likely be under pressure, as five of the regional Federal Reserve Banks have already registered declines in their manufacturing indices, and recent business sentiment indicators (while still in positive territory) have registered persistent declines. With the 2020 political season already underway, health care providers may continue to fall prey to headline risk and, more importantly, a cloudier forward earnings picture.

Technology share prices have weathered considerable volatility resulting from the point, counterpoint relating to trade. So much so that prices in the group are becoming increasingly resilient and less responsive to the news flow. When stocks stop going down on bad news, typically, the worst is over.

Fixed Income Markets
One major concern coming into 2019 has been the deteriorating fundamentals of the corporate credit market and the magnitude of the refinancings that the market will need to fund over the next three years. The broader market has now begun to voice the same concerns with key industry voices, highlighting leveraged loans and the massive growth of the BBB, barely investment grade sector of the market. With demand for coupon yield still running strong, there has yet to be a significant widening of credit spreads in the market. As such, we continue to stress higher credit quality and shorter portfolio duration for corporate bond holdings.

The unprecedented demand for municipal bonds, having outstripped the available supply, has pushed tax-exempt yields to levels below the tax equivalency level of taxable bonds. This tempers our enthusiasm for municipal bonds until adequate new issuance comes to market and restores municipal bond yields to more attractive levels.

Commodity Markets
As more data emerges regarding the status of planting and crop health, we believe the recent run-up in grain prices will turn out to be overdone and will likely encounter at least a partial retracement of the advance. The converse holds true for livestock prices, as the assumed herd reductions could prove unfounded. Energy prices, barring the outbreak of armed conflict, should decline back to levels seen earlier this year, as North American production and export volumes show no signs of peaking, and Saudi Arabia appears committed to holding on to market share in the face of rising supply.

Industrial metals are unlikely to offer much in the way of upside, as manufacturing indicators around the globe are warning of slower growth. Precious metals have reached an important technical level and could be poised to follow through on recent gains. It is unlikely they will exceed previous highs unless the central banks of the G-7 nations adopt aggressive liquidity injections to reignite economic growth. Should this happen, gold as a storehouse of purchasing power would likely serve to attract buyers.

 
Third Quarter Asset Profile

For a PDF version of this publication, click here: 2Q2019_TheRoadAhead

 

NOTE: IMPORTANT INFORMATION
Source: Unless otherwise noted, all statistics herein obtained from Bloomberg.

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